In the United States, the economic news was generally positive. Unemployment fell to 5.4% from 5.5% a month earlier, housing starts rose to the highest pace since November 2007, jobless claims remained near cyclical lows, and business investment spending rebounded from earlier weakness. The U.S. trade deficit in March jumped to its highest level in 6 years as the end of the West coast port strikes resulted in a surge of imports. The weaker trade balance was the principal factor behind a sharply lower revised estimate of U.S. GDP growth in the first quarter. Instead of the originally estimated +0.2% growth, the U.S. economy was reported to have contracted 0.7% in the first three months of the year. The news was interpreted to provide the Fed with cover for delaying its first interest rate increase until at least September or December this year.

In Europe, bond yields initially moved sharply higher. For example, 10-year German bunds which hit a record low yield of 0.05% on April 17th traded at 0.37% on April 30th and hit 0.78% in early May. An improving growth outlook and higher inflation expectations in Europe contributed to the rise in yields, but the extremely low absolute yield levels may finally have been recognized as unattractive. The sharp rise in yields caused European bond prices to fall and Canadian and U.S. bonds moved lower in sympathy. The Greek debt crisis led to a turnaround, though, as observers believed that, without a new bailout agreement, Greece would run out of cash in early June and default on its loans from the International Monetary Fund. European bonds retraced most of their losses from earlier in the month and North American bond markets followed suit.

The Canadian yield curve steepened in May as yields of 2 and 5-year Canada bonds declined roughly 10 basis points, while longer term yields actually edged higher. The lower shorter term yields suggested that investors re-evaluated their expectations of future Bank of Canada moves to include a greater possibility of another rate reduction later this year. The U.S. yield curve also steepened, but more due to higher longer term yields as short term yields were little changed. The U.S. Federal Reserve was thought unlikely to supply greater monetary stimulus and longer term investors were concerned that the Fed would begin raising interest rates later this year.

There was very little difference between the results of the three major bond sectors in May. The federal sector returned 0.21% with short federal issues substantially outperforming long term federal bonds (+0.35% versus -0.16%). The provincial sector earned 0.16% in the month. Provincial yield spreads narrowed on average by 1 basis point, which helped offset the effect of the longer average duration of the sector. The investment grade corporate sector returned 0.22% as yield spreads widened 2 basis points on average. New issue supply was moderate at $8.5 billion, which paled in comparison to the record $148 billion raised in U.S. corporate bonds in May. Non-investment grade corporate bonds earned 0.77% in the period, with energy related issues enjoying the best performance. Real Return Bonds declined 1.66% in the month, as the weaker than expected CPI data lessened demand for inflation protection.

We anticipate that the Canadian bond market will remain volatile in June. The negotiations between Greece and its creditors will likely result in numerous eye-catching headlines as both sides practice brinksmanship. We suspect that Greece’s government will ultimately accede to its creditors’ demands, but the risk of a Greek default and resultant financial crisis is non-trivial and that means bond prices may react sharply to new developments.

We stated in the January commentary that we were skeptical about the likely success of the European Central Bank’s quantitative easing programme. In particular, we pointed out that in three quantitative easing episodes in the United States, bond yields tended to rise rather than fall. So the recent jump in European bond yields is not a surprise. We believe there is room for European yields to move higher still, especially if there is an agreement between Greece and its creditors. Rising yields in Europe would result in upward pressure on North American bond yields.

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